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Credit Default Swaps: So Dear to Us, So Dangerous

This paper was written in November 2008 - two months after Lehman Brothers filed for bankruptcy and immediately triggered the financial crisis:

The credit-default swap (CDS) is a type of financial tool that has created system-wide benefits. These derivative contracts, however, have also created the potential for relatively few market participants to destabilize the entire economic system. This Paper will explore (1) how CDS could hypothetically create systemic risk, (2) how CDS have recently exacerbated the current financial crisis, and (3) how the U.S. legislature could best regulate CDS to minimize systemic risk in the future.

In theory, CDS could foster systemic crisis by means of (1) encouraging the growth of dangerous asset bubbles, (2) causing the collapse or failure of an institution that is systemically significant, or (3) creating perverse incentives that subvert policies underpinning business law on a system-wide scale. This Paper will question whether, with respect to the first theoretical risk, CDS have helped support the growth of the sub-prime mortgaged-backed securities asset bubble that has been blamed as the ultimate basis of the current financial crisis. Ultimately, there is evidence cutting both ways, thereby encouraging further research into the issue. That said, the second of these theoretical risks has certainly come into realization within the last few months when the trillion-dollar company, AIG, nearly destroyed itself by blundering in the CDS market and causing system-wide instability. As for the third theoretical risk, there is currently no empirical evidence that CDS create perverse incentives on a system-wide scale.

How should the government regulate CDS to minimize systemic risk? After examining seven distinct proposals, this Paper (modestly) proposes that legislators require CDS market participants to (1) maintain increased capital reserve requirements when involved in the purchase or sale of CDS tied to highly speculative debt; and (2) confidentially disclose their CDS positions to the Federal Reserve. Increasing the capital reserve requirements for companies that trade in junk-grade CDS is essential for two reasons. First, higher capital reserve requirements protect the solvency of systemically significant institutions that attempt to profit from the riskiest CDS. Second, specifically targeting CDS that are associated with the junk lending business will discourage banks from extending cheap credit to unworthy borrowers, thereby reducing the potential for markets to generate precarious asset bubbles. As a second regulatory measure, confidential disclosure of CDS positions to the Federal Reserve is an efficient but relatively non- intrusive way to greatly facilitate the monitoring of systemic risk going forward.

While the proposed legislative action would invariably impose costs on both market participants and society in general, the benefits of enhanced economic stability are incalculable.